Economists divided over common currency

 

Few will be surprised by the revelation that Irish economists are divided on the issue of Ireland's participation in European monetary union (EMU) without sterling. Since the publication of the ESRI report, Economic Implications for Ireland of EMU, two distinct camps have emerged. At the risk of simplification, the pro-EMU camp has come to be associated with the principal authors of the Economic and Social Research Institute (ESRI) report while the opposition comes largely from university economists. At the level preferred by the ESRI this debate appears to be about interest rates. At another level, largely ignored by the ESRI, it is about the suitability of the Irish economy for membership of a monetary union dominated by a group of countries with which, in terms of real convergence and business cycle activity, we have little in common.

ESRI economists have consistently argued that participation in the euro will inevitably result in lower Irish interest rates. This argument is usually based on two propositions. First, by eliminating exchange rate risk the euro will also eliminate the risk premium on Irish debt which implies that Irish interest rates must be lower inside than outside EMU. Under normal circumstances (though not necessarily in crises) this is correct. Second, ESRI economists unambiguously assume that the European Central Bank (ECB) will be a Bundesbank clone, so that euro interest rates will converge to pre-EMU German rates. Historically the Bundesbank has acquired its credibility with the full co-operation of successive German governments and electorates.

Whether 11 European governments and electorates will give the same support to the ECB is an open question. Given the constitutional commitment to price stability, it is by no means implausible that the ECB may decide to establish credibility by setting euro interest rates above current deutschmark levels.

However, disputes about interest rates, no matter how cleverly presented by ESRI economists, mask the real issue. In terms of macro-economic characteristics, trade structure and synchronisation of business cycle activity, Ireland has little in common with the EU economic core. From a substantial body of international research we highlight a recent paper by two economists, Mr Michael Artis and Mr Wenda Zhang, currently working at the European University Institute in Florence. They identify five EU countries - Ireland, Finland, Denmark, Sweden and the UK - whose business cycle activity differs significantly from that in the core economies. Given this, it is of some interest to note that three of these countries have decided to opt out of EMU. Ireland, on the other hand, is left as an economic and political outlier.

Although the existing evidence unambiguously excludes Ireland from any European "optimum currency area", all sides agree this would be largely irrelevant if our labour markets were sufficiently flexible to accommodate external shocks such as a sterling depreciation. Unfortunately we are not aware of any plans to reform Irish labour markets to accommodate falls in sterling such as the collapse of September 1992 or the less dramatic decline of early 1995. In the first case we were able to maintain competitiveness by devaluing within the ERM and in the second the 15 per cent bands enabled us to partly offset sterling's weakness by depreciation against the deutschmark. Once we move to full EMU membership these options will be automatically closed and the full weight of adjustment will fall on the domestic economy. Hence, preparing for the euro requires more than modifying commercial software and altering cash registers in retail stores. It also requires that we place wage-setting in a more flexible framework which enables rapid responses to external shocks. We fully agree with the ESRI in this. We also agree with their assessment that the political elites seem certain to push ahead with EMU membership with little attention to debates between economists.

Where we differ is in believing that the necessary degree of flexibility is unlikely to be negotiated in an economy already dangerously close to over-heating, with potentially disastrous consequences if sterling subsequently collapses.

Peter Neary and Rodney Thom are professors of economics at University College Dublin.